Topic 2.

Introduction to Insurance
1. Definition of Insurance
2. Characteristics of Insurable Risks
3. Managing Risks through Insurance
4. Fields of insurance

Definition of Insurance
As we have seen, there are a number of ways of dealing with risk, and
insurance is one of the most popular.
In simple terms, insurance is a method in which an individual or entity
transfers to another party the risk of financial loss from events such as accident,
illness, property damage, or death.
A company that accepts risk and makes a promise to pay a policy benefit if a
covered loss occurs is an insurer or an insurance company.
A policy benefit is a specific amount of money the insurer agrees to pay under
an insurance policy when a covered loss occurs.
An insurance policy, also known as a policy or insurance contract, is a
written document that contains the terms of the agreement between the insurer and
the owner of the policy.
The premium is the specified amount of money an insurer charges in
exchange for agreeing to pay a policy benefit when a covered loss occurs.
A number of terms are commonly used to describe the people who are
involved in the creation and operation of an insurance policy.
The applicant is the person or business that applies for an insurance policy.
Once an insurer issues a policy, the person or business that owns the insurance policy
is known as the policyowner.
In most cases, the applicant is also the policyowner. The insured is the person
whose life, health, or property is insured under the policy. In some countries, the
term assured is used to refer to the person insured. The policyowner and the insured
of a particular policy are often the same person. If, for example, you purchase an
insurance policy on your life, you are both the policyowner and the insured
(sometimes called the policyowner-insured).
In contrast, if your spouse purchases a policy on your life, then she is the
policyowner and you are the insured. A third-party policy is a policy purchased by
one person or business on the life of another person.
If the person insured by a life insurance policy dies while the policy is in force,
the insurer usually pays the policy benefit to the beneficiary.
 The beneficiary is the person or party the policyowner names to receive the
life insurance policy benefit.
A request for payment under the terms of an insurance policy is called a claim.

Characteristics of Insurable Risks

Insurance products are designed in accordance with some basic principles that
define which risks are insurable. In general, for a risk— a potential loss— to be
considered insurable, it must have the following characteristics:
■ The loss must occur by chance.
■ The loss must be definite.
■ The loss must be significant
■ The loss rale must be predictable.
■ The loss must not be catastrophic to the insurer.
A loss without these characteristics generally is not considered an insurable
risk.

The Loss Must Occur by Chance

Far a potential loss to be insurable, the element of chance must be present.
The loss must result either from an unexpected event or from an event that the
insured person did not intentionally cause. For example, people generally cannot
control whether they become seriously ill. As a result, insurers can offer medical
expense insurance policies to protect against the financial losses caused by the
chance event that an insured person will become ill and incur medical expenses
When this principle of loss is applied in its strictest sense to life insurance, an
apparent problem arises: death is certain to occur. The timing of an individual’s
death, however, is usually out of the individual’s control. Therefore, although the
event being insured against— death— is a certain event rather than a chance event,
the timing of that event usually occurs by chance.
The Loss Must Be Definite
For most types of insurance, an insurable loss must be definite in terms of time
and amount. In other words, the insurer must be able to determine when to pay
policy benefits and how much these benefits should be. Death, illness, disability,
and old age are generally identifiable conditions. The amount of the financial loss
resulting from these conditions, however, can be subject to interpretation One of the
important terms of the contractual agreement between an insurance company and
the policyowner is the amount of the policy benefit that will be payable if a covered
loss occurs while the policy is in force. Depending on the way in which a policy
states the amount of the policy benefit, every insurance policy can be classified as
being either a contract of indemnity or a valued contract.
A contract of indemnity is an insurance policy under which the amount of the
policy benefit payable for a covered loss is based on the actual amount of the
financial loss that results from the covered event, as determined at the time of the
event. For example, some types of health insurance policies pay benefits based on
the amount of the insured’s covered financial loss or a maximum amount stated in
the contract, whichever is less.
A valued contract specifies the amount of the policy benefit that will be pay-
able when a covered loss occurs, regardless of the actual amount of the loss that was
incurred. Life insurance policies are valued contracts because they specify the
benefit that the insurer will pay when the insured dies while the policy is in force.
Some life insurance policies, such as decreasing term life insurance policies,
provide that the amount of the benefit may change over the life of the policy. These
policies are still considered valued contracts because the changes in the amount of
the benefit are based on factors that are not directly related to the amount of the
actual loss that will result from the insured’s death.
The Loss Must Be Significant
As described earlier, insignificant losses, such as the loss of an umbrella, are
not normally insured. The administrative expenses of paying benefits when a very
small loss occurs would drive the cost for such insurance protection so high in
relation to the amount of the potential loss that most people would find the protection
unaffordable.
On the other hand, some losses would cause financial hardship to most people
and are considered to be insurable. For example, a person injured in an accident may
lose a significant amount of income if she is unable to work. Disability income
insurance coverage is available to protect against such a potential loss.
 The Loss Rate Must Be Predictable
No one can predict the losses that a specific person will experience. We do
not know when a specific person will die or whether a person will become disabled
or need hospitalization, let alone how much these events may cost. However, insur-
ers must have some way of predicting future losses so that they can determine the
proper premium amounts to charge policyowners.
Although individual losses cannot be predicted, insurers can provide a specific
type of insurance coverage if they can predict the loss rate — the frequency of losses
— that the insureds are likely to experience. To predict the loss rate for a given group
of insureds, the insurer must be able to predict the number and timing of covered
losses that will occur in that group of insureds.
Insurers can predict with a fairly high degree of accuracy the number of people
in a given large group who will die, become disabled, or require hospitalization
during a given period of time. These predictions are based on observations of past,
events and a concept known as the law of large numbers.
The law of large numbers states that, typically, the more times we observe a
particular event, the more likely that our observed results will approximate the true
probability— or likelihood—that the event will occur in the future.
A classic example of the law of large numbers is the coin toss. If you toss a
fair coin— one that has not been altered to influence outcomes— there is a 50-50
probability that the coin will land with the head side up. If you toss the coin 10 times,
you might not get an equal number of heads and tails. However, if you toss the coin
10,000 times, in approximately 50 percent of the tosses, the coin will land with the
head side up and the other 50 percent of the tosses will land on tails. The more often
you toss the coin, the more likely you will observe an approximately equal
proportion of heads and tails.
Insurance companies rely on the law of large numbers when they make predic-
tions about the covered losses that a given group of insureds is likely to experience
during a given time period. Insurers collect specific information about large numbers
of people so that they can identify the pattern of losses that those people experienced.
For many years, for example, U.S. life insurance companies have recorded how
many of their insureds of each sex have died and how old they were when they died.
Using these statistical records, insurance companies have been able to develop
charts— called mortality tables— that indicate with great accuracy the number of
people in a large group (100,000 people or more) who are likely to die at each age.
A mortality rate is the rate at which death occurs among a specified group of people
during a specified period, typically one year. Mortality tables show the mortality
rates that are expected to occur in a group of people at a given age.
Insurance companies have developed similar charts, called morbidity tables,
which display morbidity rales, or the incidence of sickness and accidents, by age,
occurring among a given group of people. By using accurate mortality and morbidity
tables, life and health insurers can predict the probable loss rates for given groups of
insureds. Insurers use those predicted loss rates to establish premium rates that will
be adequate to pay claims.
The Loss Must Not Be Catastrophic to the insurer
A potential loss is not considered insurable if its occurrence is likely to cause
or contribute to catastrophic financial damage to the insurer. Such a loss is not insur-
able because the insurer could not responsibly promise to pay benefits for the loss
and still meet its other obligations.
To prevent the possibility of catastrophic loss and ensure that losses occur
independently of each other, insurers spread the risks they choose to insure. For
example, major natural disasters such as hurricanes or earthquakes can damage or
destroy a large number of properties in a concentrated area. In the past, some insurers
failed because they were unable to pay claims following a disaster. For this reason,
property insurance companies today usually limit the number of properties they will
insure in any particular geographic area.
Alternatively, by purchasing reinsurance, an insurer can reduce the possibility
that it will suffer catastrophic losses. Reinsurance is insurance that one insurance
company—known as the direct writer or ceding company—purchases from another
insurance company—known as the reinsurer or assuming company— to transfer
all or part of the risk on insurance policies that the direct writer issued.
For example, if Alpha Life Insurance Company (the direct writer) purchases
reinsurance from Celtic Reinsurance Company (the reinsurer), then Celtic accepts
some or all of the risk on the insurance policies Alpha has issued. By entering into a
reinsurance agreement with a reinsurer, an insurer can provide relatively large
amounts of coverage without exposing itself to an excessive amount of risk.

Managing Risks through Insurance

Based on the preceding definition, an insurance plan or arrangement
typically includes the following characteristics:
■ Pooling of losses
■ Payment of fortuitous losses
■ Risk transfer
■ Indemnification
Pooling of losses
You may wonder how an insurance company can afford to be financially
responsible for the economic risks of its insured. Insurers use a concept known as
pooling. With risk pooling, individuals who face the uncertainly of a particular
loss— for example, the loss of income due to a disability-— transfer this risk to an
insurance company. Insurance companies knew that not everyone who is issued a
disability income policy will suffer a disability. In reality, only a small percentage
of the individuals insured by this type of policy will actually become disabled.
 By collecting premiums from all individuals and businesses that wish to
transfer the risk of disability, insurers spread the cost of the relatively few losses that
are expected to occur among all the insured persons. Insurance thus protects against
the risk of economic loss by applying a simple principle:
If the economic losses that actually result from a given peril, such as
disability, can be spread across a large pool (or number) of people who are all
subject to the risk of such losses and the probability of loss is relatively small for
each person, then the cost to each person will be relatively small.
Thus, pooling implies (1) the sharing of losses by the entire group and (2) the
prediction of future losses with some accuracy based on the law of large numbers.
The primary purpose of pooling, or the sharing of losses, is to reduce the variation
in possible outcomes as measured by the standard deviation or some other measure
of dispersion, which reduces risk. For example, assume that two business owners
each own an identical storage building valued at $50,000. Assume there is a 10
percent chance in any year that each building will be destroyed by a peril, and that a
loss to either building is an independent event. The expected annual loss for each
owner is $5,000 as shown below:
Expected loss = 0.90 * $0 + 0.10 * $50,000 = $5,000
A common measure of risk is the standard deviation, which is the square root
of the variance. The standard deviation (SD) for the expected value of the loss is
$15,000, as shown below:

Suppose instead of bearing the risk of loss individually, the two owners decide
to pool (combine) their loss exposures, and each agrees to pay an equal share of any
loss that might occur. Under this scenario, there are four possible outcomes:

If neither building is destroyed, the loss for each owner is $0. If one building
is destroyed, each owner pays $25,000. If both buildings are destroyed, each owner
must pay $50,000. The expected loss for each owner remains $5,000 as shown
below:
 Note that while the expected loss remains the same, the probability of the
extreme values, $0 and $50,000, have declined. The reduced probability of the
extreme values is reflected in a lower standard deviation as shown below:

Thus, as additional individuals are added to the pooling arrangement, the

standard deviation continues to decline while the expected value of the loss remains
unchanged. For example, with a pool of 100 insureds, the standard deviation is
$1,500; with a pool of 1,000 insureds, the standard deviation is $474; and with a
pool of 10,000, the standard deviation is $150.
In addition, by pooling or combining the loss experience of a large number of
exposure units, an insurer may be able to predict future losses with greater accuracy.
From the viewpoint of the insurer, if future losses can be predicted, objective risk is
reduced. Thus, another characteristic often found in many lines of insurance is risk
reduction based on the law of large numbers.
Payment of Fortuitous Losses
A second characteristic of private insurance is the payment of fortuitous
losses. Most insurance policies exclude intentional losses. A fortuitous loss is one
that is unforeseen and unexpected by the insured and occurs as a result of chance. In
other words, the loss must be accidental. The law of large numbers is based on the
assumption that losses are accidental and occur randomly. For example, a person
may slip on an icy sidewalk and break a leg. The loss would be fortuitous.
Risk Transfer
Risk transfer is another essential element of insurance. With the exception of
self-insurance, a true insurance plan always involves risk transfer. Risk transfer
means that a pure risk is transferred from the insured to the insurer, who typically is
in a stronger financial position to pay the loss than the insured. From the viewpoint
of the individual, pure risks that are typically transferred to insurers include the risk
of premature death, excessive longevity, poor health, disability, destruction and theft
of property, and personal liability lawsuits.
Indemnification
A final characteristic of insurance is indemnification for losses.
Indemnification means that the insured is restored to his or her approximate financial
position prior to the occurrence of the loss. Thus, if your home burns in a fire, a
homeowners policy will indemnify you or restore you to your previous position. If
you are sued because of the negligent operation of an automobile, your auto liability
insurance policy will pay those sums that you are legally obligated to pay. Similarly,
if you become seriously disabled, a disability-income insurance policy will restore
at least part of the lost wages.
 Insurance Underwriting
Mortality and morbidity tables provide insurers with broad general statistics
to help them estimate how many people of a certain age and sex will die or become
ill in the future. However, not all individuals of the same sex and age have an equal
likelihood of suffering a loss. Individual insurance is sold on a case-by-case basis,
and insurers cannot presume that each proposed insured represents an average
likelihood of loss.
When an insurer receives an application for insurance, the company must
assess the degree of risk it will be accepting if it issues the policy. The process of
assessing and classifying the degree of risk represented by a proposed insured and
making a decision to accept or decline that risk is called underwriting or risk
selection. Insurance company employees who are responsible for evaluating pro-
posed risks are called underwriters.
Proper underwriting is vital for an insurer’s success and even its survival. The
premium rates that an insurance company establishes are based in large part on the
amount of risk the company is assuming for the policies it issues. The greater the
risk insured represents, the higher the premium rate the insurer must charge. If the
insurer consistently underestimates the risks that it assumes, its premium rates will
be inadequate to provide the benefits promised to all its policyowners. On the other
hand, if the insurer overestimates the risks it will be assuming, its premium rates
may be considerably higher than those of its competitors, and potential customers
will purchase insurance elsewhere.
Underwriting becomes more difficult because of antiselection, also known as
adverse selection or selection against the insurer. Antiselection is the tendency of
individuals who believe they have a greater-than-average likelihood of loss to seek
insurance protection to a greater extent than do other individuals. For example,
people who believe they are in poor health are more likely to apply for life and health
insurance— and also to apply for larger amounts of coverage—than people who
believe they are in average or good health. The possibility of antiselection requires
an insurer to carefully review each application to assess the degree of risk the
company will be assuming if it issues the requested policy.
Underwriting consists of two primary stages: (1) identifying the risks that a
proposed insured presents and (2) placing the proposed insured into an appropriate
risk class.
Identifying Risks
Although predicting when a specific individual will die, become injured, or
suffer from an illness is impossible, insurers have identified a number of factors that
can increase or decrease the likelihood that an individual will incur a loss. The most
important of these factors are physical hazards and moral hazards. A physical hazard
is a physical characteristic that may increase the likelihood of loss.
For example, a person with a history of heart disease possesses a physical
hazard that increases the likelihood that the person will die sooner than a person of
the same age and sex who does not have a similar medical history. A person’s
activities or lifestyle can also present a physical hazard. Tobacco use and alcohol or
substance abuse are known to contribute to health problems, and those health
problems may result in higher-than-average medical expenses and a lower-than-
average life expectancy. Similarly, an occupation such as coal mining, which
exposes a person to a significantly greater-than-average risk of health problems or
accidental injury, can present a physical hazard. Underwriters must carefully
evaluate proposed insureds to detect the presence of such physical hazards.
Moral hazard is a characteristic that exists when the reputation, financial posi-
tion, or criminal record of an applicant or a proposed insured indicates that the
person may act dishonestly in the insurance transaction. For example, an individual
who has a confirmed record of illegal or unethical behavior is more likely than an
individual without this type of background to act dishonestly in an insurance
transaction. The person may be seeking insurance for financial gain rather than as
protection against a financial loss. Therefore, an insurer must carefully consider that
fact when evaluating the individual’s application for insurance. Underwriters also
evaluate the moral hazards presented by individuals who provide false information
on their applications for insurance. In these cases, the applicants may be trying to
obtain coverage that they might not otherwise be able to obtain. When underwriters
evaluate applications, they take a variety of steps to identify proposed insureds who
present moral hazards.
Classifying Risks
After identifying the risks that a proposed insured presents, the underwriter
places the proposed insured into an appropriate risk class. A risk class is a grouping
of insureds who represent a similar level of risk to the insurer. Assigning proposed
insureds to risk classes enables the insurer to establish equitable premium rates to
charge for the requested coverage. People in different risk classes are charged
different premium rates, much the same as people of different ages are charged
different rates. Without these premium rate variations, some policyowners would be
charged too much for their coverage, while others would be paying less than the
actual cost of their coverage.
Each insurer has its own underwriting guidelines, which are the general rules
it uses when assigning proposed insureds to an appropriate risk class. Individual life
insurers' underwriting guidelines usually identify at least four risk classes for
proposed insureds: standard risks, preferred risks, substandard risks, and declined
risks.
■ Proposed insureds who have a likelihood of loss that is not significantly
greater than average are classified as standard risks, and the premium rates they are
charged are called standard premium rates. Traditionally, most individual life and
health insurance policies have been issued at standard premium rates.
■ Proposed insureds who present a significantly lower-than-average
likelihood of loss are classified as preferred risks and are charged lower-than-
standard premium rates known as preferred premium rales. Insurance company
practices vary widely as to what qualifies a proposed insured as a preferred risk or a
standard risk.
■ Proposed insureds who have a significantly greater-than-average likelihood
of loss but are still found to be insurable are classified as substandard risks or
special class risks. For example, a proposed insured may have been diagnosed with
a disease such as diabetes, which can lead to a shorter life expectancy.
For individual life insurance, insurers typically charge substandard risks a
higher-than-standard premium rate, called a substandard premium rate or special
class rate.
■ The declined risk category consists of those proposed insureds who present
a risk that is too great for the insurer to cover. In addition to proposed insureds with
a poor health history, those who engage in exceptionally risky activities, such as sky
diving or mountain climbing, are sometimes classified as declined risks.
Because tobacco use represents a major health hazard, almost all insurers
today take a proposed insured’s tobacco use into account in their underwriting guide-
lines. Some insurers have established separate rate classes for tobacco users and
tobacco nonusers, such as “standard tobacco user” and “standard tobacco nonuser.”
Other insurers place proposed insureds who use tobacco in a less favorable risk class
than tobacco nonusers. For example, a tobacco user who might otherwise be
classified as a preferred risk is instead classified as a standard risk.
Insurable Interest Requirement
As noted earlier, insurance is intended to compensate an individual or a
business for a financial loss, not to provide an opportunity for gain. At one time,
however, people used insurance policies as a means of wagering. In eighteenth-
century England, for example, people frequently purchased life insurance on the
lives of famous people, especially those who were reportedly ill, hoping to make a
profit, if the insured person died.
The practice of purchasing insurance as a wager is now considered against
public policy. As a result, laws in the United States and many other countries require
that a policyowner have an insurable interest in the risk that is insured at the time
the policy is issued. An insurable interest means that the policyowner must be likely
to suffer a genuine loss or detriment should the event insured against occur.
To understand how insurable interest requirements are met, we need to con-
sider two possible situations: (1) an individual purchases insurance on her own life
and (2) an individual purchases insurance on another's life. In both cases, the
applicant for life insurance must name a beneficiary.
All persons are considered to have an insurable interest in their own lives.
A person is always considered to have more to gain by living than by dying.
Therefore, an insurable interest between the policyowner and the insured is
presumed when a person seeks to purchase insurance on her own life.
 Insurable interest laws do not require dial the beneficiary have an insurable
interest in the policyowner-insured’s life. In other words, the laws allow a
policyowner-insured to name anyone as beneficiary. Most insurance company
underwriting guidelines, however, require dial die beneficiary also have an insurable
interest in die life of the insured when a policy is issued. As a result, life insurers
typically inquire into the beneficiary’s relationship to die proposed insured and may
refuse to issue the coverage if the beneficiary does not possess an insurable interest
in the proposed insured’s life.
In the case of a third-party policy, laws in many countries and in most states
in the United States require only that the policyowner have an insurable interest in
the insured’s life when the policy is issued. Most insurance company underwriting
guidelines and the laws in some states, however, require both die policyowner and
the beneficiary of a third-party policy to have an insurable interest in the insured’s
life when the policy is issued.
Certain family relationships are assumed by law to create an insurable interest,
between an insured and a policyowner or beneficiary. In these cases, even if the
policyowner or beneficiary has no financial interest in the insured’s life, the bonds
of love and affection alone are sufficient to create an insurable interest. According
to the laws in most jurisdictions, the insured’s spouse, mother, father, child, grand-
parent, grandchild, brother, and sister are deemed to have an insurable interest in die
life of the insured.
Figure illustrates the family relationships dial create an insurable interest.

Family Relationships that Create an Insurable Interest

An insurable interest is not presumed when the policyowner or beneficiary is
more distantly related to the insured than the relatives previously described. In these
cases, a financial interest in the continued life of the insured must be demonstrated
to satisfy die insurable interest requirement.
 Example:
Mary Mulhouse obtained a $50,000 personal loan from the Lone Star Bank.
Analysis:
If Mary dies before repaying the loan. Lone Star could lose some or all of the
money if lent her. Therefore, Lone Star has a financial interest and, consequently,
an Insurable interest in Mary's life, in the amount of the outstanding loan.
Similar examples of financial interest can be found in other business
relationships.
The insurable interest requirement must be met before a life insurance policy
will be issued. After die life insurance policy is in force, die presence or absence of
insurable interest is no longer relevant. Therefore, a beneficiary need not provide
evidence of insurable interest to receive the benefits of a life insurance policy.
The insurable interest requirement also must be met when a health insurance'
policy is issued. For a health insurance policy, the insurable interest requirement, is
met if the applicant can demonstrate a genuine risk of economic loss should the
proposed insured require medical care or become disabled. Typically, people seek
health insurance for themselves and tor their dependents. In both of these cases, the
applicant has an insurable interest in the continued health of the proposed insured.
Additionally, for disability income insurance purposes, businesses have an insurable
interest in the health of their key employees.
Example:
Didactic Training is a small company that contracts with other companies to
conduct seminars for their management staffs. Shilpa Gouda works for Didactic as
its primary seminar leader. Because Shilpa's expertise and teaching skills are
essential to the success of the business. Didactic has applied for disability income
coverage on Shilpa and has named itself as the beneficiary of this coverage.
Analysis:
Didactic would be unable to meet its scheduled seminar commitments if
Shilpa were ill or injured and, thus, unable to conduct seminars. Therefore, Didactic
has a financial interest in Shilpa's continued good health. This financial interest
creates the necessary insurable interest for Didactic to purchase disability income
coverage on Shilpa.

THE FIELDS OF INSURANCE

Insurance is a broad, generic term, embracing the entire array of institutions
that deal with risk through the device of sharing and transfer of risks.
Insurance may be divided and subdivided into classifications based on the
perils insured against or the fundamental nature of the particular program. Basically,
the primary distinction is between private insurance and government insurance.
 Private insurance consists for the most part of voluntary insurance programs
available to the individual as a means of protection against the possibility of loss.
This voluntary insurance is usually provided by private firms, but in some instances,
it is also offered by the government. The distinguishing characteristics of private
insurance are that it is usually voluntary and that the transfer of risk is normally
accomplished by means of a contract.
Government insurance, in contrast, is compulsory insurance, usually
operated by the government, whose benefits are determined by law and in which the
primary emphasis is on social adequacy. In general, the benefits under social
insurance programs attempt to redistribute income based on some notion of “social
adequacy.”
Private (Voluntary) Insurance
As noted, private insurance consists of those insurance programs that are
available to the individual as protection against financial loss. It is usually (but not
always) voluntary, and generally (but not always) based on the concept of individual
equity. Some private insurance coverages are compulsory, and although the
emphasis is on individual equity, private insurance for some classes of insureds is
subsidized either by government or by other insureds. Furthermore, although most
private insurance is sold by private firms, in a number of instances, it is offered by
the government.
Today, private insurance may be classified into three broad categories:
■ Life insurance
■ Health insurance
■ Property and liability insurance
Life Insurance Life insurance is designed to provide protection against two
distinct risks: premature death and superannuation. As a matter of personal
preference, death at any age is probably premature, and superannuation (living too
long) does not normally strike one as an undesirable contingency. From a practical
point of view, however, a person can, and sometimes does, die before adequate
preparation has been made for the future financial requirements of dependents. In
the same way, a person can, and often does, outlive income-earning ability. Life
insurance, endowments, and annuities protect the individual and his or her
dependents against the undesirable financial consequences of premature death and
superannuation.
Health Insurance Accident and health insurance (or, more simply, health
insurance) is defined as “insurance against loss by sickness or accidental bodily
injury.” The “loss” may be the loss of wages caused by the sickness or accident or it
may be expenses for doctor bills, hospital bills, medicine, other expenses of long-
term care. Included within this definition are forms of insurance that provide lump-
sum or periodic payments in the event of loss occasioned by sickness or accident,
such as disability income insurance and accidental death and dismemberment
insurance.
Property and Liability
Property insurance indemnifies property owners against the loss or damage
of real or personal property caused by various perils, such as fire, lightning,
windstorm, or tornado.
Liability insurance covers the insured’s legal liability arising out of property
damage or bodily injury to others; legal defense costs are also paid.
Property and liability insurance is also called property and casualty insurance.
In practice, nonlife insurers typically use the term property and casualty insurance
(rather than property and liability insurance) to describe the various coverages and
operating results.
Casualty insurance is a broad field of insurance that covers whatever is not
covered by fire, marine, and life insurance; casualty lines include auto, liability,
burglary and theft, workers compensation, and health insurance.
The property and casualty insurance coverages can be grouped into two
major categories—personal lines and commercial lines.
Personal lines refer to coverages that insure the buildings and personal
property of individuals and families or provide them with protection against legal
liability. Commercial lines refer to property and casualty coverages for business
firms, nonprofit organizations, and government agencies.
The property and liability (casualty) insurance includes the following
types of insurance:
■ Property insurance, also sometimes referred to as fire insurance, is
designed to indemnify the insured for loss of, or damage to, buildings, furniture,
fixtures, or other personal property as a result of fire, lightning, windstorm, hail,
explosion, and a long list of other perils. Originally, fire was the only peril insured
against, but the number of perils insured against has gradually been expanded over
the years. Today, two basic approaches are taken with respect to the perils for which
coverage is provided. Under the first approach, called named-peril coverage, the
specific perils against which protection is provided are listed in the policy, and
coverage applies only for damage arising out of the listed perils. Under the second
approach, called open-peril coverage, the policy lists the perils for which coverage
is not provided, and loss from any peril not excluded is covered. Coverage may be
provided for both direct loss (i.e., the actual loss represented by the destruction of
the asset) and indirect loss (i.e., the loss of income and/or the extra expense that is
the result of the loss of the use of the asset protected).
■ Marine insurance, like fire insurance, is designed to protect against
financial loss resulting from damage to owned property, except that here the perils
are primarily those associated with transportation. Marine insurance is divided into
two classifications: ocean marine and inland marine.
 Ocean marine insurance policies provide coverage on all types of oceangoing
vessels and their cargoes. Policies are also written to cover the shipowner’s liability.
Originally, ocean marine policies covered cargo only after it was loaded onto the
ship. Today the policies are usually endorsed to provide coverage from “warehouse
to warehouse,” thus protecting against overland transportation hazards as well as
those on the ocean.
Inland marine insurance seems like a contradiction in terms. The field
developed as an outgrowth of ocean marine insurance and “warehouse-to-
warehouse” coverage. Originally, inland marine insurance developed to cover goods
being transported by carriers such as railroads, motor vehicles, or ships and barges
on the inland waterways and in coastal trade. It was expanded to cover
instrumentalities of transportation and communication such as bridges, tunnels,
pipelines, power transmission lines, and radio and television communication
equipment. Eventually, it was expanded to include coverage on various types of
property that is not in the course of transportation but that is away from the owner’s
premises.
■ Automobile insurance provides protection against several types of losses.
First, it protects against loss resulting from legal liability arising out of the ownership
or use of an automobile. In addition, the medical payments section of the automobile
policy consists of a special form of health and accident insurance that provides for
the payment of medical expenses incurred as a result of automobile accidents.
Coverage is also provided against loss resulting from theft of the automobile or
damage to it from many different causes.
■ Liability insurance embraces a wide range of coverages. The form with
which most students are familiar is automobile liability insurance, but there are other
liability hazards as well. Coverage is available to protect against nonautomobile
liability exposures such as ownership of property, manufacturing and construction
operations, the sale or distribution of products, and many other exposures.
■ Workers compensation insurance had its beginning (in the United States)
shortly after the turn of the century, when the various states began to pass workers
compensation laws. Under these laws, the employer was made absolutely liable for
injuries to workers that arose out of and in the course of their employment. Workers
compensation insurance provides for the payment of the obligation these statutes
impose on the employer.
■ Equipment breakdown insurance (also referred to as boiler and
machinery insurance) was introduced in the late 1800s to cover the explosion hazard
inherent in early boilers. It was later expanded to include coverage for accidental
breakdown of a wide range of types of equipment. More recently, with advances in
automation, it was further expanded to include coverage for virtually all types of
equipment. To prevent losses, equipment breakdown insurers maintain an extensive
inspection service, and this service is a primary reason for the purchase of the
coverage. Although the contract does not require them to do so, the insurers make
periodic inspections of the objects insured. As a result, losses are reduced and the
insured benefits.
■ Burglary, robbery, and theft insurance protect the property of the insured
against loss resulting from criminal acts of others. Because a standard clause in these
crime policies excludes acts by employees of the insured, they are referred to as
“nonemployee crime coverages.” Protection against criminal acts by employees is
provided under fidelity bonds.
■ Credit or trade credit insurance is a highly specialized form of coverage
(available to manufacturers and wholesalers) that indemnifies the insured for losses
resulting from their inability to collect from customers. The coverage is written
subject to a deductible based on the normal bad-debt loss and with a provision
requiring the insured to share a part of each loss with the insurer.
■ Title insurance is yet another narrowly specialized form of coverage.
Basically, it provides protection against financial loss resulting from a defect in an
insured title. The legal aspects of land transfer are rather technical, and the
possibility always exists that the title may not be clear. Under a title insurance policy,
the insurer agrees to indemnify the insured to the extent of any financial loss suffered
as a result of the transfer of a defective title. In a sense, title insurance is unique in
that it insures against the effects of some past event rather than against financial loss
resulting from a future occurrence.

SUMMARY
■ In simple terms, insurance is a method in which an individual or entity
transfers to another party the risk of financial loss from events such as accident,
illness, property damage, or death.
■ From the viewpoint of a private insurer, an insurable risk ideally should
have certain characteristics.
– The loss must occur by chance.
– The loss must be definite.
– The loss must be significant.
– The loss rale must be predictable.
– The loss must not be catastrophic to the insurer.
■ The typical insurance plan contains four elements:
– Pooling of losses
– Payment of fortuitous losses
– Risk transfer
– Indemnification
 Pooling means that the losses of the few are spread over the group, and
average loss is substituted for actual loss. Fortuitous losses are unforeseen and
unexpected, and they occur as a result of chance. Risk transfer involves the transfer
of a pure risk to an insurer. Indemnification means that the victim of a loss is restored
in whole or in part by payment, repair, or replacement by the insurer.
■ The law of large numbers states that the greater the number of exposures,
the more likely the actual results will approach the expected results. The law of large
numbers permits an insurer to estimate future losses with some accuracy.
■ The process of assessing and classifying the degree of risk represented by a
proposed insured and making a decision to accept or decline that risk is called
underwriting or risk selection. Underwriting consists of two primary stages: (1)
identifying the risks that a proposed insured presents and (2) placing the proposed
insured into an appropriate risk class.
■ An insurable interest means that the policyowner must be likely to suffer a
genuine loss or detriment should the event insured against occur.
■ Insurance can be classified into private and government insurance. Private
insurance consists of life and health insurance and property and liability insurance.
Government insurance consists of social insurance and other government insurance
programs.